Outlook for 2026: International and small-cap equities are best positioned

• Tim Murray
  Capital markets strategist
  T. Rowe Price

Fiscal expansion is just getting underway, which will further boost spending on AI (artificial intelligence), and the Trump administration’s prioritisation of deregulation should lead to healthy growth for the overall economy in 2026. However, looking at the various asset classes, valuations appear to be excessive almost across the board, which clouds the outlook. Where does our Asset Allocation Committee see tactical opportunities for asset allocation in this environment?

Inflation risk leads to underweighting of bonds

While expansionary fiscal policy, including tax incentives for investment, will support growth, many of the US government’s measures are also inflationary. These include restricting immigration and introducing tariffs. Regardless of whether inflation remains close to 3% – above the Federal Reserve’s target – or accelerates in 2026, it will reduce the value of bonds. This leads us to favour equities over bonds.

The expansion of AI infrastructure accounts for a large part of this – housing construction and private spending are lagging behind.

International and small-cap equities are best positioned

Comparing the outlook for international and US equities, we see more upside potential for non-US equities as they catch up with the US in AI-related sectors. In addition, the Chinese government appears determined to promote innovation in AI and other technologies to offset the economic losses and rising unemployment caused by the sharp downturn in the country’s property market.

Although fiscal stimulus in the US is substantial, the shift towards expansionary measures outside the US – particularly in countries such as Germany – has been more abrupt, so we expect it to have a greater impact in relative terms. The European Central Bank, the Bank of England and many emerging market central banks have also eased monetary policy much more aggressively than the Fed, providing additional support for international equities.

While we are neutral on growth and value stocks in the US, we favour value stocks in international equities. The global economic environment is improving, and sectors such as financials, which are heavily weighted in value indices, should benefit from steeper yield curves and rising credit demand. Valuations for non-US value stocks also remain relatively attractive.

We expect stock market performance to broaden somewhat beyond US mega-cap technology stocks and believe that small caps will benefit most from this shift. Given the enormous market capitalisation of the “Magnificent Seven”, even a moderate shift towards small caps would represent a relatively large boost for smaller stocks. Small caps also tend to benefit most from lower short-term interest rates, which contributes to our decision to slightly overweight small-cap equities.

Preference for high-yield bonds and exposure to non-US currencies

In our fixed income allocation, we view high-yield bonds as an attractive way to benefit from a strong economy with less risk than equities. The overall credit quality of this asset class is at its highest level in years, and we do not anticipate a deterioration in fundamentals in 2026. Non-investment grade bonds also have some duration, which would cushion the asset class should the economy fall into recession.

We favour some currency risk in fixed income through local currency bonds from international developed and emerging markets. The decline in the US dollar during most of 2025 is likely to continue into 2026 as the Fed cuts short-term interest rates while other central banks are already much further along in their easing cycles. In addition, inflation in the US remains stubborn and could even rise further. We see an overweight position in unsecured local non-US bonds as an attractive opportunity to benefit from this trend.

In summary

We favour equities over bonds, as we believe the two-speed economy will avoid recession, and we favour exposure to non-US currencies to benefit from the likely weakness of the US dollar.